APR and interest rate are two terms that are often used interchangeably, but they are actually very different. One describes the advertised rate of interest charged for borrowing money while the other includes interest and fees.
Obviously, this can really matter when you want to take out a personal installment loan or line of credit since it affects your overall cost of borrowing. Both are expressed as percentage rates, but don’t be confused. They are not the same.
Interest Rate Defined
Interest rates go up and down, depending on how the Federal Reserve sees the economy. In times of recession, interest rates tend to be low. In times of inflation, interest rates rise to curb borrowing. Lenders also decide how much they charge each borrower, based on their creditworthiness and lending policies.
Most companies eagerly display their interest rate, or nominal interest rate, because it tends to be a lower amount than an annual percentage rate (APR). That’s because the interest rate is only calculated on the principal of your loan. This is the amount you asked to borrow.
As an example, you may want to take out a personal installment loan of $12,000 at a 8% interest rate. Your annual interest expense would be $12,000 x 8 = $960 per year, or $80 per month. However, this doesn’t necessarily give you an accurate picture of what your loan will actually cost you, because it excludes additional costs the lender might charge you.
What is APR (Annual Percentage Rate)?
Your annual percentage rate is usually higher than the advertised interest rate, because it includes other costs associated with borrowing. A common extra expense is an origination or administration fee of between 0.5% to 10% of your loan amount.
Using the example mentioned above for a loan of $12,000, your loan could cost you between $60 and $1,200 more, on top of whatever your charges for interest on the loan. Some lenders also charge agency fees on top of interest and administrative costs.
APR vs Interest Rate
All lenders must pre-disclose information such as the APR and the nominal interest rate for every consumer loan. They also follow the same rules to ensure potential borrowers have access to the same information.
The Truth in Lending Act is meant to promote honesty and clarity so borrowers can fully understand the cost of borrowing before they have a legal obligation to repay. By revealing the APR and the interest rate a borrower can get an idea of how much the lender is charging them in extra fees.
Luckily, many lenders do not charge extra fees so the APR can be the same as the stated interest rate. Some lenders also offer a 0% APR deal, providing you have great credit.
How is APR Calculated?
You’ll need to consider the following factors if you want to calculate the APR on a personal installment loan yourself:
- Interest rate
- Loan amount (principal)
- Additional fees
- Number of days the loan will last
Formula To Calculate The Annual Percentage Rate
APR = ((Interest + Fees / Loan amount) / Number of days in loan term)) x 365 x 100
Example of Using the APR Formula
Let’s say you decide to borrow $2,000. The fees are $200 and the loan has an interest rate of 5% over two years.
- Calculate the simple interest on the loan.
Interest = Principal x Rate x Term in Years
Interest = $2,000 x .05 x 2 = $200
- Add the fees to the interest
$200 + $200 = $400
- Divide this by the loan amount
400 / 2,000 = 0.2
- Divide this by the number of days in the loan term
0.2 / 720 = 0.00027397260274
- Multiply by 365, the number of days in a year
0.00027397260274 x 365 = 0.1
- Multiply by 100 to get a percentage
0.01 x 100 = 10 or 10% APR
As you can see, the interest rate is only 5%, but the true cost of borrowing is twice that amount at 10% APR. That’s why it is worthwhile to work out the APR on prospective loans. A personal loan through one lender can appear to be a good deal, but it can actually be much more expensive than a competitor’s offering.
Comparing Credit Products
The APR is usually the most reliable indicator for finding the most affordable personal installment loan. Always check this number carefully and choose the same term length to get an accurate picture of costs.
Does 0% APR mean you do not pay interest? Yes, but you should still be careful. Some 0% APR agreements are temporary. You could pay nothing extra for the first six months and then a higher annual percentage rate afterwards.
What Is a Good APR?
Clearly, the best scenario is when your APR is 0%. Even so, a low APR is still better than a higher one. Generally, those with excellent credit get the best APRs, but that often depends on the lender.
Good APRs can also rely on factors such as how competitive the market is and the current prime rate. When the prime rate is low, lenders often offer 0% APRs to attract more customers. Just remember to check whether this rate is for the entire personal loan term, or just an introductory offer.
While the annual percentage rate can give you a more accurate picture of your borrowing costs instead of the interest rate alone, it isn’t a foolproof method.
Potential Issues with Annual Percentage Rates
Even though consumer protection laws are meant to clarify what’s involved in borrowing, lenders have a lot of discretion regarding what they may or may not include as fees when they calculate their APR on a personal loan.
Read the fine print to make sure you won’t pay additional fees outside of those included in the APR. Some lenders don’t include certain fees, fines, or late payment penalties in their calculations. If this is the case, their APR may actually understate your total cost.
Of course, this makes it difficult to compare financial products because the fees included or excluded varies from institution to institution. Still, it is worth the extra effort to check the fine print to avoid paying more than you should when you’re considering a particular loan.
When weighing several possible personal installment loans, always check whether they have fixed or variable APRs too. As the names suggest, a fixed annual percentage rate remains the same throughout the life of the loan. A variable APR loan has an interest rate that may change at any time. This can greatly affect your cost to borrow.
APR & APY Are Not the Same
Don’t confuse APR with APY (annual percentage yield). APR measures the amount of interest you pay when you borrow. APY has nothing to do with borrowing. It measures the amount of interest you earn through compound interest when you invest or save.
As a result, a lower APR is always best when you’re borrowing and a high APY is always best when you’re saving.
Can Late Payments Affect My Loan’s APR?
Potentially, yes. Some lenders impose an APR penalty that is higher than the normal interest rate if your payment is late. They may also charge you late fees of between $25 and $50, which increases your cost to borrow considerably.
Can I Lower the APR on My Personal Loan?
Yes, in some cases. If the lender does not charge a pre-payment penalty, early repayment can lower the APR since you reduce your total number of interest payments. Lenders may use various names for this fee such as unwinding cost, early termination fee, exit fee, or interest guarantee, but they’re all the same thing. They’re meant to compensate the lender for interest lost when you pay more than your scheduled payments. This includes making extra payments or paying your loan off early.
Luckily, many lenders do not charge pre-payment penalties, but some do so always check before you borrow.
The Bottom Line
Clearly, lenders know that most people look at interest rates. Consequently, they use them to entice borrowers. Yet, interest rates alone don’t give you the full picture. Always check to see what other fees the lender may charge you as this definitely increases your costs.
Fortunately, many lenders offer reasonable rates and no-fee borrowing. Read the fine print, compare APRs on any loans you’re considering, and choose the best from those. It pays to be cautious, since it saves you time and money in the long run.
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